Method in the Madness

"Though this be madness, yet there is method in it" - Polonius in William Shakespeare's Hamlet, referring to the eponymous hero.

         Global markets have been on a slow (or in the case of emerging Asian markets quite fast) downward trajectory over the last week or so as the world gets itself into a panic that the Fed might be beginning to taper. I've discussed before the seeming irrationality to most of us of this flight from risk at the precise moment when the Fed is indicating to us that the life support will only be reduced on signs that things are recovering. And as more good news from the US seems to indicate that the tapering might start as soon as September, global equity and bond markets have seen a flight out of these assets with the fear of what might happen next seemingly reducing investors appetite for risk.

        In my first post a couple of months ago, I raised the possibility of whether central banks had created an inescapable cycle. I questioned whether the low interest rates and QE stimulus had driven the equity market rise, and the possibility that any removal of this stimulus could lead to a fall in these global markets with a potential impact on the real economy as a result, thus forcing a return to further stimulus measures. This seemed to show some elements of truth based on the market reactions to Bernanke's various comments on tapering and following positive economic news in the US, with global market sell offs at each point. 

             The popular theory at the moment is that the tapering by the Fed is going to begin in September, especially with the encouraging GDP and job figures over the last few weeks. The market, anticipating this, has seen 10 year US treasury yields up at 2.88% and a fall in the S&P 500 and other stock markets around the globe. However whilst the fall in equity markets in emerging economies such as Philippines, Thailand and Indonesia has been quite significant, the S&P 500 currently only sits 3.8% below the high of 1,708 at 1,645 (as of last night's close). To put this in perspective, this is still 4.5% higher than the level when the market fell shortly after Bernanke gave his speech clarifying his forward guidance policy. So despite the market knowing that tapering was coming, and the feeling that it was likely to begin in September for some time, equity markets in the developed western economies are above the level they were at immediately post the initial announcement. 

            If we work on the assumption that equity markets have already priced in what they know or believe, then the effect of the reduction in QE being used in September should already be reflected in the prices. This is not to say that the market won't react negatively when it happens, but the last few months seem to have demonstrated that once the market digests the news, it will then continue to climb based on the underlying economic fundamentals. These economic fundamentals are, improving GDP growth figures in the US, UK and Eurozone and improving, albeit slowly, unemployment figures in all 3 regions as well. Perhaps the use of forward guidance has already enabled the market to adjust to what is going to happen in the near future, and after the initial panic, the correction appears to reflect the real economic improvement in the economy. If this is the case, then forward guidance is doing it's job. The market is preparing itself already for a reduction in the stimulus, therefore the shock effect when it does actually occur is likely to be less. Assuming the real economy continue to improve as they are at the moment, then the equity market will continue to move forward. 

             Many market commentators are wary of forward guidance, stating it is madness to give firm figures in advance to the market. But if the market has already priced in slowly the effect of a reduction in QE, then from Bernanke's perspective if this be madness, there is indeed a method in it. That method may well be working, but I guess we'll only really find out soon.

A new dawn for the UK, let's hope it's not loonie!

As Nina Simone famously sung

"Birds flying high you know how I feel, Sun in the sky you know how I feel, breeze driftin' on by you know how I feel, It's a new dawn, It's a new day, It's a new life and I'm feeling.......... mildly optimistic"

Well, she didn't quite finish like that, but if she was writing that song in the UK at the moment she might prefer my altered version.

Wednesday marked a new dawn for monetary policy in the UK with the formal introduction of forward guidance as part of the monthly inflation report. I've covered my thoughts on forward guidance being a positive progression before so now it's in place I thought it would be useful to have a quick look at what the policy is.

         In brief the BoE has now indicated it is going to tie it's monetary policy to the level of unemployment in the UK in addition to targeting inflation, but with the emphasis being that inflation must remain under control first and foremost.

In the words of the Bank of England (MPC by the way stands for Monetary Policy Committee of the BoE - those that decide these things!)

"In particular, the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%, subject to the conditions below. 

The MPC stands ready to undertake further asset purchases while the unemployment rate remains above 7% if it judges that additional monetary stimulus is warranted. But until the unemployment threshold is reached, and subject to the conditions below, the MPC intends not to reduce the stock of asset purchases financed by the issuance of central bank reserves and, consistent with that, intends to reinvest the cash flows associated with all maturing gilts held in the Asset Purchase Facility."

The caveat for all of this is inflation and the markets. 

                   Inflation in the UK is currently around the 2.9% mark. The target level for inflation is required to be around 2%, although it's rarely been at that level for quite some time. The BoE has predicted that inflation will likely remain roughly at about 2.5% for the next 18-24 months, however their reputation in accurately predicting this has been relatively unsuccessful. They are likely to accept a level of inflation which stays roughly at the current level. If however inflation starts to increase even more, then they could look to reduce their asset holdings, or increase rates, to control inflation before unemployment is near breaking below that 7% level. 

               With the financial stability indicator it is a lot more vague as to what might cause the BoE to adjust it's forward guidance stance. The only indication is a point when "the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC". What these financial stability indicators are could include a large list of issues - over spiraling house prices, a devaluation in the pound to a non-beneficial level - the list could be endless, but the BoE doesn't specify.

In addition to all of this, the BoE signed off their statement indicating that even if these "knockouts" (consistent high inflation breaches or financial instability) were reached this doesn't necessarily mean they'll reverse course. 

So far so hazy! If compared to the Fed's attempts at forward guidance a couple of months ago it seems a lot less clear cut. But then maybe, wary of the way the market reacted to the Fed trying to give a clear positive picture, the BoE felt the need to reassure markets that nothing was set in stone. The timelines given by Mark Carney for UK improvement were also on the more pessimistic side compared to the US, which potentially emphasises the need for more caution in their guidance. UK unemployment currently sits at 7.8%. The medium term equilibrium rate for unemployment in the UK is estimated at being around 6.5%. But the BoE suggests that unemployment won't get towards the 7% threshold until 2016, indicating interest rates to remain low, and QE to remain in place, for a further 2.5 to 3 years - a full year and a half beyond the Fed's estimates for the US. 

         These timelines don't particularly inspire reason for optimism. But these are perhaps the safest estimates for them to give based on their projections and will of course be subject to change if things improve more rapidly. I think it is better to give a more leveled outlook on this rather than promote over exuberance and over optimism by making people think the rate will be increased earlier, if they don't believe it to be so. If that 7% threshold is met within the next year, then the BoE will act earlier in order to reduce QE and begin raising rates. There has already been positive signs for the UK Economy over the last few months with growth (although small) over the last 2 quarters and other key indicators showing things are gradually improving (despite the negative spin the BBC might always try and use!). So I think there is reason for optimism, we just have to be realistic that this is just the start and things will hopefully slowly take shape, even if it isn't as quick as the US, it's almost certainly going to be quicker than Europe.

         As for Mark Carney's first foray into forward guidance in the UK. We now have further clarity over what the Bank of England is going to be looking to when it is deciding monetary policy. We have a clearer unemployment rate, which is published each month for all to see, as well as the previously known target level of inflation. All in all it helps both the market and the individual to better plan for the future, which is a good thing. Everything is always subject to change in life, but at least the parts of the puzzle which help determine where interest rates are going to go is more visible. The first level of forward guidance whilst providing clarity in terms of observable levels has though left some uncertainty as to when the Bank might have to sway away from their current projections, so maybe in time more clarity around this aspect would be helpful. 

            I found out last week that the nickname for the Canadian dollar is "the Loonie". The Canadian at the head of the BoE will be striving to ensure the English press don't christen him similarly. He's made a good start, so for now he'll be alright, but if there's too much increase in the haziness they might just be tempted! 

Have a good weekend!

The Loonie, not to be confused with.......

......the Loony

The Age of Austerity - a necessity for all?

            This weeks posting seeks to look at the issue of Austerity and whether it is a necessity as a way out of the current crisis. Whilst Austerity has been the favoured solution for many countries to reduce deficits now to help stimulate growth, serious questions have been raised as to whether it is actually undermining growth. Countries such as the UK with control over its own currency and monetary policy should perhaps not be too concerned at this point with a rising debt level so long as spending is targeted at the right areas. Unfortunately for other countries, such as those struggling in the Eurozone, a lack of economic tools leaves them with no choice but to follow austerity potentially for years to come.           

                    Austerity. The word has become one of the most used and looked up since the crisis began in 2008. In 2010 it was named word of the year by Merriam-Webster's Dictionary. We are, according to the prime-minister David Cameron in a speech given in 2009, living in the "Age of Austerity". From an economic perspective, it is defined on Wikipedia as describing "policies used by governments to reduce budget deficits during adverse economic conditions. These policies may include spending cuts, tax increases, or a mixture of the two. Austerity policies may be attempts to demonstrate governments' liquidity to their creditors and credit rating agencies by bringing fiscal incomes closer to expenditures."

                As we know we are currently in the worst recession since the 1930s. Many governments (including the UK) have been running large deficits for many years and have been forced to increase the amount of borrowing required to fund those deficits drastically due to the (whisper it quietly) “banking crisis”. Countries such as Ireland, Greece and Portugal have required bailouts from the EU and IMF because their fiscal deficits grew so large that the fear of default drove up their borrowing costs to a level leaving them unable to borrow sufficiently in the market. The conditions required for them to accept these bailouts was to pursue austerity to attempt to reduce their national debt as a % of GDP and that, as a result of this, growth would flow back to these countries. The UK under the existing government has also attempted to follow an austerity path looking to reduce the size of the UK deficit and in turn keep the size of the borrowing to a containable level.

                The idea of resorting to large fiscal deficit reduction in the midst of a recession as a means to attempt to control the national debt level gained popularity in the early years of the current crisis due to a paper by renowned economists Carmen Reinhart and Kenneth Rogoff. In their paper “Growth in a Debt in Time” they attempted to demonstrate that once a developed country’s debt gets to a level of 90% of GDP or above then this will cause economic growth to slow substantially. As a result, countries need to work to reduce their debt levels to keep them below the 90% bound. If they fail to do so, the crisis in confidence can provoke “very sudden and “unexpected” financial crises. At the very minimum, this would suggest that traditional debt management issues should be at the forefront of public policy concerns.” As a result of this paper many countries, especially those in the Eurozone and the UK saw austerity as a core tool to maintain market confidence. The hope being that a narrower deficit or better a surplus (and as a result smaller Debt/GDP ratio) will then lead to increased private sector and foreign investment and ultimately to a return to sustainable growth.

             This method is significantly different from previous traditional measures used in order to return economies to growth. As mentioned in this blog previously one such method is monetary stimulus. Through the reduction in interest rates (and other such recent efforts like QE) it should encourage the private sector to save less and invest their money in infrastructure (and hopefully not just the stock market!) which in turn will multiply through and lead to a growth in the economy. As we know this has already been enacted by the central banks in the UK, US and Eurozone.

                      The other method conventionally used by governments in the midst of a recession is for them to spend their way out of it. A method which has been in use since Keynes at the height of the Depression.  Fiscal stimulus involves increased government spending and/or a reduction in taxes. The theory is by the government spending more, through investment in construction for example, it will multiply through to other parts of the economy leading to increased spending elsewhere and ultimately to growth. Meanwhile a reduction in taxes should lead to an increase in the number of pounds in firms’ and individuals’ pockets with the hope that they spend it on investment or goods and services which itself will lead to improved overall economic performance.

Fiscal stimulus however is obviously at odds with the idea of austerity. So is austerity really the right method or should we be trying to spend our way out of this recession despite the rising debt levels?

           

                       One of the problems with trying to ascertain whether any policy or method is the correct way forward is the partisanship of those who promote and criticise each method. At the economists level those that are pro-austerity such as Reinhart and Rogoff are prepared to defend their paper and stance despite increasing evidence there may be flaws in their argument. Meanwhile on the other side are economists such as Paul Krugman who believes that austerity should not be undertaken. It is hard to find any middle ground or potentially constructive conversation as neither side seems to want to meet in the middle instead of vehemently sticking to their guns (and indeed criticising the other). On the political side, one only needs to try and read the Wikipedia entry on the UK Government Austerity Programme to get a glimpse of the polarity of the issue. The site has a warning at the top stating the neutrality of the article has been called into question given its perceived strong anti-government stance.

            

                         The use of Reinhart-Rogoff’s theory itself has in the past 6 months been heavily called into question. It follows the discovery that they were missing some data which proved crucial to their findings. The 90% debt-GDP ratio, used by them as the critical point for governments, is now seen as quite arbitrary and not a level which can be used by every country as the perilous point which must not be passed. Meanwhile there is evidence to the contrary which shows that it is slow growth which leads to higher debt levels and not the other way round. This make more sense because as the economy slows down governments will spend more in order to try to stimulate it, leading to an increase in the deficit and, if there is not equivalent increase in GDP at that time, an increase in the debt-GDP ratio. So where does this leave us?

                        

               The reality is it depends on the country’s individual situation, their access to all the tools necessary and the markets perception of their ability to recover and cover their debts.

                    

                        This week I was introduced to the writings of an economist called Cullen Roche. Roche has written an excellent paper around about how money works in modern society under a theory known as monetary realism. According to Roche, Monetary Realism “seeks to describe the operational realities of the monetary system through understanding the specific institutional design and relationships that exist in a particular monetary system”. The paper itself is well worth a read for its insights into how the money system works in the modern world. Even if it is more specific to the US, it gave me a good insight as to some of the issues faced by other economies around the globe. One of the more interesting aspects which I gauged from this was that the US, or a similar economy with full control over its currency and issuing debt in its own currency, should in theory not need to go bankrupt (i.e. default on paying its debts) if its debt were to increase too much. Should there not be demand in the market for US Treasuries being issued (i.e. they cannot borrow enough to cover their deficit or repay existing debt) then the Fed could simply print more money to cover whatever shortfall there has been. This, of course, is only up to a point, but with the US that point would be relatively high due to the diverseness of the US economy.  The big risk is that excessive money printing will result in a high inflationary environment and potentially a weakening of the dollar (and resulting increase in cost of imports) which in turn could have a real impact on the cost of living of the inhabitants. However it is only once it reaches near to this point that there is the real risk, and the hope would be that the economy has been corrected before that point and as a result tightening and a reduction of the debt can then be achieved during a period of growth.

                         

                           As Roche mentions, “government cannot just spend and spend or the extra flow of funds and net financial assets in the system could cause inflation, drive up prices and reduce living standards. It’s important to understand that government cannot just spend recklessly.” It’s thus vitally important government spending is done in an efficient manner because as he points out, “if spending is misdirected or misguided there is a very real possibility this will simply result in higher inflation that is not offset by increased production.” Governments need to invest in projects which will lead to both short, medium and long term growth by having an impact through private sector investment. Needless spending on infrastructure projects such as new bridges, new roads or the like where they have no real long term benefit, whilst providing an injection in the short term, will only be detrimental in the long run. This is where the government needs to get the right balance, which admittedly can be quite difficult.

                              

                         If we look at the UK, we can see it operates economically in a similar format to the US. It issues debt in its own currency, has a relatively diverse economy and has the power to control its own money supply and currency. The UK government has officially been following a plan of national austerity. However if you were to actually look at what has been happening with the current account deficit and national debt it is visible that the government expenditure is actually growing. The last year saw the deficit increased to 3.7% of GDP after being only 1.5% of GDP in Jan 2012. Meanwhile the national debt has expanded from being 73.9% of GDP in 2010 to currently being 90.7% of GDP. Inflation however is now currently at 2.8% but had previously consistently been above this since the crisis started. So despite the increased borrowing, inflation has not spiked. The cost of borrowing for the UK government in the meantime is still only 2.4% yield on 10-year Gilts, down from 3.4% in 2010 when the base interest rate was already 0.5% at that time. As the evidence we saw earlier seems to suggest, there is no reason to fear such an increase in the debt level for the UK above the previously thought 90% danger level. A quick look at Japan sees a country with a Debt to GDP level of over 200% but still with very low borrowing costs and extremely low inflation if not at times deflation. Whilst I am not trying to use Japan as a beacon of economic health, it is a useful comparison to show that having a higher Debt-GDP ratio will not necessarily cause the sort of high (or hyper) inflation and borrowing costs used as fear by those who wish to curb spending completely.

                          

                          From the evidence, I would suggest that the Government in the UK, whilst talking about austerity now, should take the long term view of boosting spending now, in the hope that the real austerity and cut backs can be carried out at a point when the economy is already growing sufficiently on its own. Such examples are with the help to buy scheme and HS2 projects. Whether these will ultimately be “roads to nowhere” or will actually drive things forward in years to come can only wait to be seen and highlights the problems governments have in identifying areas which will assist real long term growth as well as just short term boost. The past 2 quarters have seen slow, slow signs of growth returning to the UK with 0.3% and 0.6% in Q1 and Q2 respectively, but whether this will gather momentum in itself in the coming years will depend on continued government assistance now. The key is that once the UK does start on a path of sustainable growth that this period is then used to begin to reduce down the debt through increased tightening in unnecessary areas of expenditure. This depends very much on the political will of all sides to ignore partisanship and do what is best for the country.

                       

                   Europe on the other hand, especially the peripheral Europe of Portugal, Ireland, Greece and Spain do not have a similar amount of flexibility. Due to the constraints of being unable to issue debts in a currency under their own control, as well as having no control over monetary policy, has left these struggling economies at the mercy of the demands of the markets. True, the excesses during the boom years have pushed these economies to the state they are currently in. However their lack of ability to use monetary policy in order to assist in stimulating the economy and easing the downward spiral have seen these countries fall further into depression than they might otherwise have done. Any attempts by them to try to use fiscal expansion as a method to drive their way out would have been met with a market pushing borrowing costs up to unacceptable levels that the countries would have no option but to default. In the cases of Ireland, Greece and Portugal this has already led to each country requiring bailouts from the EU and IMF. The ECB, needing to play the role a central bank is required to in these situations, has its hands tied in trying to meet the requirements of stronger economies such as Germany versus those in trouble. As such they can only really deal with items on a macro level. This is visible when you hear the ECB often talk about Eurozone growth as a whole which is held up by the strongest economies. In the same way talk last week that the worst is over is premature in my mind. Whilst the Eurozone as a whole may slowly begin to make its way towards growth, the troubled economies are a long way off recovery, as Greece’s continued need for assistance is evidence of.

                        

                 While Paul Krugman beats a drum against austerity, the unfortunate reality for Ireland, Greece and Portugal is that there is no alternative choice due to the pressures of the market. Should any of these economies attempt to move away from austerity then the borrowing costs reflected in the market would only serve to push all these economies back towards default. Such results were seen by the spike in both the Portuguese Bond Yields and CDS spread (the market measure of risk of Portuguese default) at the hint that the coalition may split over a lack of willpower for further deficit reduction. Whilst I agree with Krugman that austerity will not assist these countries in regaining growth the simple truth of the matter is that due to market forces and the lack of tools available there is no other option available. The result will be that these countries, especially Greece, will continue to suffer for many years to come until ineffective spending is reigned in.

             

                        A big difference I believe in the responses of the different economies to austerity measures however can be seen in the response of the people and the opposition political parties. It is no surprise that Ireland is seen as the poster boy of austerity. As Mohammed El-Erian recently wrote “Right or wrong, Ireland will stick with austerity. Efforts to regain national control of the country’s destiny, the Irish seem to believe, must take time.” This is reflected in the relative lack of mass protest compared to Spain, Portugal and Greece as well as in the fact that the main opposition party Fianna Fail publicly backs the austerity measures. With the 3 most recent quarters of GDP showing a further contraction in the Irish economy, the indicators are that it will take time for Ireland to recover but they are in comparatively better shape than the other troubled Eurozone nations. The acceptance that current hardships are necessary after the excesses enjoyed by the majority of the population is perhaps an indicator to the other countries to desist from political brinkmanship and complaint and to pitch in and attempt to stop the slide together.

                     

                    In conclusion, the evidence to me seems to indicate that austerity, in the true sense of the word, is not going to help bring growth back to troubled economies. For countries such as the UK and US, a pull back from unnecessary spending in certain areas should be carried out, but there is no risk at the moment from an increase in debt levels so long as the additional spending is targeted effectively. Once the economies are growing sufficiently, that is the time to reign in further avoidable government spending and seek to reduce the debt. Unfortunately due to the constraints on peripheral Eurozone of both market forces and a lack of monetary control there is no choice for them but to concentrate on dramatically reducing their debt levels and spending now. The political debate about who was to blame in the first place will wrangle on for years, but the truth is that everyone in one way or another gained from the financial excess. The key for now is not to concentrate on the blame but to implement the solution. Unfortunately, depending on the country will depend how much control over the solution your government has.

Structured Products – They’re not for everyone, but you shouldn’t just dismiss them!

Before you start, this one might not be for the fainthearted. I’m writing this in response to an article I read entirely dismissing structured products. In my response I’ve tried my best to simplify as much as possible what are, by their very nature, complex products in the hope of persuading you that there are 2 sides to this conversation. While a lot of these products should not be touched by individual investors, sometimes and in some circumstances they could be of use for the individual, so long as they properly understand what it is they are buying. As a result I hope to make the point that making a blanket stay away message on any financial product should at least show the whole picture to let investors make their own minds up. Now with any luck I haven’t scared you off too much before you start! On the contrary, I hope I’ve encouraged you to expand your knowledge, so please read on!

                         Earlier this week I stumbled upon an article written for MoneyWeek telling people to steer completely clear of structured products (“Don’t fall for structured products”). That no one should invest in them ever because they are all rubbish and the investor would always lose out. The author based her complete dismissal of all of these products on a couple of new products she’d been sent which she deemed to be too risky to even think about, because mostly there was too much downside potential for the investor with a very limited upside. Whilst I believe she had a point in reference to the two products she mentioned, it struck me very much as being a severe case of using two bad examples for the purpose of dismissing everything in that field. It’s a bit like telling me I should keep my money under a mattress because the 2 savings accounts I looked at give 0% interest and are both at nearly bankrupt banks, so as a result there’s no point saving in any savings accounts (although some might argue at the moment it’s just as effective!). In reality what you’d do would be to look out for the best account for you which offers the best return. All financial products are essentially the same from that respect.

               

                         Now I’m aware that a large number of the people reading the blog will be wondering what on earth I’m talking about when I speak of structured products. Sure, I well know my family and most of my friends used to look at me confused when I mentioned I worked with structured derivatives. They still came out wondering what it was I did when I tried to explain. But, for the hope of not boring those already in the industry, I think it’s worthwhile to give those not in the know a brief overview. 

                     In relatively simple terms, a structured product uses derivatives on a mixture of different assets to create a tailored payoff for the investor. This mix of assets could include anything (bonds, equity indices, individual stocks, fx etc.). Most of you will probably have heard of some of the more infamous structured products which assisted in bringing about the financial crises – Mortgage Backed Securities (MBS), Collateral Debt Obligations (CDOs) for example - and in it you can already see some of the dangers of certain of these products. The specific types of structured product discussed in the money week article however are what are known as equity structured notes.

                  Equity structured notes themselves can take many forms, but it effectively will give you a payoff linked to the performance of a single equity or index or a group of equities/indices over a period of time. The main benefit of these products is that they will sometimes offer to protect your capital somewhat (in a process known as capital protection) through selling you a bond as part of the structure. (It’s important to know at this point, that this capital protection is provided by the institution that is issuing the product, so there is a risk there.) These products can range massively in complexity from the simple ones, offering you only the upside on the performance of an index, or they can be extremely complex, involving all sorts of caveats as to what your return will be based on. There are whole books written and still to be written on these, but hopefully you have the very basic gist. As you can see, even from the off they’re not for everyone!

                  The moneyweek article focused on 2 particular products both of whose payoff was on the slightly more complex side for a basic investor. In them, the investor only got a small coupon each quarter from their investment and even this was dependent on all 3 stocks used in the product performing positively over the 2 year timeframe. If all 3 shares fell by more than 20% in that time, then you stood at risk of losing some if not all of the capital you put in (although to lose all your capital HSBC, BP and Vodafone’s share price would all have to fall to 0, an apocalyptic thought for any pension fund holder!). As you can see, a product of this kind has inherent risks and this is one where the upside certainly doesn’t seem to necessarily compensate for the downside. So if you were now interested in either of these products as a private investor I’d suggest you read what I wrote a few weeks ago on the difference between speculation and gambling so you can decide which it is you are doing and whether blackjack is more suitable.

               But they’re not all this complex. What if you could buy a structured note which pretty much guaranteed your capital 100% and also gave you a 55% coupon after 5 years? All that you’d need would be for the FTSE 100 to be above what it was now in 5 years time, just by 1 point. If it is you get your money back as well as 55%, if it isn’t then you get the capital you invested back. Or alternatively what if you similarly were offered a coupon of 4 times the performance of the S&P 500 over the next 5 years up to a maximum of 80% with your capital similarly protected should the S&P 500 finish below the current rate? There’s certainly reasons not to take these products. After all, the FTSE 100 may perform better than 55% in that time frame and you’ve then lost out so in theory you would have been better off buying directly into a FTSE 100 tracker and holding it for the 5 years. If the S&P 500 finishes below today’s level then you only get your money back with no return effectively eroding the value of the money you had when you could have just put it in a savings account and at least earned some interest. But therein as always lies the benefit of hindsight. As an investor, we could always have made more money if we had a time machine.

                  If I had offered you these products 4 years ago in 2008, with all the uncertainty that was around then, there’s a fair chance that some of you would have found these quite appealing. Barclays offered these exact products back then and they wouldn’t have been the only ones. Markets were trading near lows not seen since 2003 with the FTSE around the 3600 mark and S&P around 700. There was uncertainty as to how much they were likely to rise in the next few years and meanwhile with interest rates approaching or already at their all-time lows there was not much to be returned by keeping your money in a savings account. Given all that uncertainty, some investors may have assessed that markets were going to go up, but it was difficult to see how much, and there was the possibility that in 5 years time they could be near to where they currently were. You’re afraid of losing your capital if you invest directly in the market, so the capital protection element gives you comfort around that, (assuming you have faith the institution issuing will still be around then). In addition the prospect of a 55% return should the FTSE have been even 1% above its level at the time is a better prospect than only 1% by just sticking your money in a FTSE tracker. So for an investor who had a mildly positive view on the FTSE 100 over that 5 year period, but wasn’t so convinced on the size of the upside and also wanted to protect his investment, this may have suited him. It offered some kind of security and the potential for a decent return of 55% so long as the FTSE was in even a small element of positivity after the 5 years. There are plenty of this type of product available today from various institutions.

But of course there are risks, after all there’s no such thing as a free lunch!

• Loss of upside: On the simplest level you may feel you’ve protected yourself against any falls, but you’ve also limited yourself on the upside. However as a cost of giving yourself protection, you have to accept that you won’t be able to take advantage should markets really take off. It’s the choice you make. In the end, you want to make sure you get the return you are aiming for. So long as you’ve done that then there should be no regrets.                                                                                            
• The Capital Protection Risk (Counterparty Risk): As I alluded to before, the capital protection is only as good as the company which issues the note. There’s no sure thing in this world, and you need to know who is telling you they’re protecting your money because if they go under then your money goes under. It is estimated that investors held in the region of $18bn worth of Lehman Brothers issued structured products when they declared bankruptcy! Those investors now need to queue up with all the other creditors to see what they’ll get back. It’s important to assess who is guaranteeing your capital but, as Lehman proved, nothing is assured.                                                                               
• Liquidity Risk (The ability to sell): In theory the structured products that individual investors can buy are tradeable on the market, so the investor can sell the product as and when they want. In reality however there are only a limited number of each note issued each time, and the ability to sell is, as with any security, based on the willingness of someone to buy. As a result whilst there is a market on offer, if things don’t turn out as you’d hoped and you want to get out before the note reaches the end of its life, you may not get back as much as you’d hoped.                                                                    
• Complexity: As I mentioned much earlier, structured notes can be very complex. Even notes which appear to offer a very simple payoff at the end may contain several features whereby your capital may be affected should the index or underlying share hit certain levels. Like an antibiotic, always read the label. You want to make sure you’ve read the entire termsheet and all the caveats so you know what will happen to your money! Don’t just be taken by the high potential return offered if you can’t figure out how you get there. Even if you can understand it, it doesn’t necessarily make it a good investment compared to a simpler solution. 

                   As you can see from all of this, these products are certainly not for everyone and in some cases it’s debateable whether the risks make them suitable for any individual investor. They can b complex, but it doesn’t mean you shouldn’t try to educate yourself to understand them. There are times and in certain situations where there is the potential for an individual investor to make a true risk assessment on an equity structured note and deem it to be a better fit to his/her risk profile at that moment in time than a straight investment into an equity or equity index. That is the decision for the individual investor to make. I’m not a financial advisor, nor do I claim to be offering financial advice. I’ve previously spent 8 years working with structured equity traders so I probably have more knowledge on this than most of the general public but I stand to make no money by explaining them. Are they suitable for everyone? Certainly not. Are they suitable for most people? No way. But that doesn’t mean you should just reject them out of hand. Everyone deserves to understand a bit more of what they’re being told to steer clear from so they can make their own decisions. Hopefully I’ve gone a little further in doing that!

Much ado about nothing?

            It's got to the end of the week and I've decided to write this week's article about nothing. Well, not quite nothing, but the fact that nothing's really changed in the last month. That no matter how much the financial media and the markets might want to scrutinize, examine the tone of, or rearrange what's been said by Fed chief Ben Bernanke, nothing he said at various times differs from what he first stated on June 19th.

Bernanke Praying for the markets and media to just understand what he's saying!

       To briefly recap on his statement back then, he stated that if the economic data is roughly consistent with the Fed's forecast, it could then be appropriate to moderate the pace of purchases later this year through to the first half of next year, potentially ending purchases around mid-year 2014. But, no one should draw the conclusion that the policy is to end purchases in the middle of next year, because the purchases are tied to what happens in the economy. If the economy does not improve along the lines that they expect, then they will provide additional support.

           A few weeks later Bernanke followed this up in a Q&A session on July 10th. He reiterated that interest rates were not going to rise in the immediate future until unemployment was below 6.5%, inflation was under control around the target level, and even then only if the economy itself was showing sustainable signs. But he also said that there was a mix of instruments involved, and that asset-purchases (QE) was the other component than interest rates, indicating as he did the previous month that this is what would be reduced first. However, what he also stated was that, "highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy". This was, according to the media and markets reversing track on what he had said in June and encouraging the stock market at least to hit the same levels as June 18th.

          Then over the last couple of days while giving his semiannual statement to congress he mentioned that there was no "preset course" for ending QE and that any change would depend on how the economy was doing, stating "What we’re looking for is a pick-up as the year progresses. We’re going to look at the data. It’s a committee decision. It’s going to depend on whether we see the improvement which I described.” This time, finally, the market (and media) translated this as him actually saying they won't take action until the economy is strong enough to support it, with the S&P 500 hitting a new record high of 1,693.

            So just to clear it all up in case you weren't listening........

June 19th: Bernanke tells us all that should things improve to the targets as projected they'll ease off QE but only if things do indeed get better and there is no set policy. Market Drops and analysts and media throw a tantrum.

July 10th: Bernanke states there are targets to get to. Not to assume it will happen or assume there is a set policy. Market begins heading upwards and media tells us he's backing down.

July 17/18: Bernanke repeats that there are targets to get to. Not to assume it will happen or assume there is a set policy because it all depends on the data. Market hits new record high and media laud softening of his stance.

From where I'm sitting, nothing's changed in what's been said, only the media and investors have decided that he's changed his mind because of their tantrum.

       Imagine a child wanting to go and play football with his Dad. "Dad, can we go and play football?". "Sure", the Dad says, "In an hour once I've finished mowing the lawn". The kid tantrums and screams to his father, "It's not fair, you won't play football with me". The father responds "Don't worry, I will play football with you, I just have to finish the lawn first". The kid starts to perk up "Can we play football now?", "Sure", says the Dad, "I'm nearly finished so we'll play shortly". The kid is now happy as he waits for his Dad to finish.

        Sometimes you have to tell a child something a few times for them to understand what you said. You may need to slightly change the wording each time, just like the father above to get his child to understand. It's not that he won't get to play football, he just has to wait for the grass to be mowed first. That's a kid. A kid is growing, learning, needs simple things explained sometimes. Here we're talking about  supposedly knowledgeable investors and media analysts. You might expect a kid to misunderstand a clear statement, to interpret it in a different way when it's first mentioned and then change his interpretation when the same thing's said again.

        Bernanke repeated the same agenda 3 times in the last month. Nothing's changed, it seemed pretty clear first time round. Yet unfortunately there's a big kid out there who either doesn't listen or tries to only hear the bad side without listening to the good (or sensible) of what they're told first time around.  So he's got to repeat himself in a different way so they understand. Do they understand, I'm still not convinced they do. The kid needs to learn quickly that there's a straight talking agenda and all they need to do is listen properly. That way the tantrum won't be necessary and they (and we) can breathe easier. I guess it's just all part of growing up in a new world.

S&P 500 19th Jun-18th Jul (c) Bloomberg

Forward Guidance - Forward Thinking or Increasing the Pressure?

            Last Thursday 4th July, the FTSE 100 rose by over 3% in just one days trading. Given the current  irrationality of the markets, one could have been mistaken for believing it was a display of national exuberance with the markets making a prediction of Andy Murray ending Britain's Wimbledon hoodoo. The movement however was rather in response to the opening performance of a Canadian, and it wasn't Greg Rusedski.  As has been widely spoken about, Mark Carney became the first foreigner to become the Governor of the Bank of England (BoE), the body in charge of monetary policy in the UK. Last week represented the first interest rate announcement following his taking on the role and with it brought in a new era in how the BoE seems certain to conduct itself in the future.

           On the first Thursday of every month the BoE announces the base interest rate, and has historically only provided a statement with the announcement if there was a change to the rate, or as has been the case more recently, if there has been amendment to the size of QE or other changes in policy. This month, for the first time there was a statement released despite there being no change in policy as the BoE prepared the UK and the markets for the start of forward guidance. Forward guidance is when central banks indicate potential future monetary policy with reference to their projections for the economy. This is in contrast to how the BoE (and many other central banks including the ECB) has previously operated in purely announcing the policy decisions for that month with no future indications of when rates may change or QE may end (or whether in fact it may increase).

         There has been a lot of debate in the markets and the media over the positive and negative effects of having a forward guidance. Criticisms have included the fear that if the predictions made turn out to be inaccurate then the credibility of the central bank is put at risk, with investors losing trust in their ability to have an impact on the economy. Other worries are that statements could be misinterpreted by the markets causing damaging asset movements, such as pushing up the bond yields in a country, which ultimately could have a negative impact on the economy. This, ultimately, could then lead to the banks projections failing to be fulfilled and thus leading to a credibility problem. I spoke about one of these previous market misinterpretations in the reaction to Bernanke's forward guidance in the post a couple of weeks ago whilst there was a similar misinterpretation (and sell off) when Australia's chief central banker attempted to introduce a bit of humour into the Reserve Bank of Australia's decision to keep rates the same.

          There are more positive sides to having such a transparent and indicative process and I believe these outweigh the potential risks. In most walks of life it is fair to say that communication and how things are communicated can be a crucial difference between success and failure. By giving the market an indication of how they believe the economy is likely to perform in the next couple of years, and giving guidance as to the use of the tools being considered over that period gives the markets a clarity which should only assist them in their forward thinking. The uncertainty as to what a central bank might do has often had drastic consequences on assets which in itself have caused a damaging effect on the economy and potentially led to central banks acting in a manner which they had not previously planned to do. Removing this uncertainty should hopefully remove such potential volatile reactions.

             This is becoming increasingly important now for the BoE as there begins to be a divergence in the performance of the US economy with that of the other economies. Previously the markets have been able to work on the assumption that the US, EU and UK are all working in the same direction and that all their central banks will continue with loose monetary policy in order to assist in getting their respective economies out of the doldrums. Now, with the Feds most recent announcement (using forward guidance) that they could consider stopping QE in the US, should the economy recover as they expect it to, it is important for the other central banks to provide clarity to their own positions with similar transparency. UK Gilt Yields had seen a similar rise to their US counterparts following Ben Bernanke's speech indicated to the markets that there was a risk of rising interest rates in the future. This despite there being no indication that the UK was going to do the same. Mark Carney's first monthly rate decision statement thus quickly served to separate out the BoE's policy from the Fed stating "The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy." This served to ease the upward pressure on Gilt yields causing them to drop slightly off the back of the BoE drawing attention to the fact that the UK is in no current position to follow the example of the US and begin thinking about tighter monetary policy. The statement pointed to the fact that although "recovery is in train...it remains weak by historical standards and a degree of slack is expected to persist for some time." It was no coincidence that Mario Draghi of the ECB indicated they too would also look towards giving forward guidance in the future.

            All of this should only be seen as only a positive step by investors and indeed by the media. What is important however is that the predictions given by the BoE (and ECB) are seen as purely that, predictions. Looking back at thing in hindsight by others is often the end for those who try to make accurate predictions for the future. The media especially are quick to pounce upon those in positions of power to remind them of what they predicted when it turns out differently. It is important to remember that the predictions are based on the data and projections available today and are purely used as a guidance as to what is perceived as the likely outcome, and how monetary policy will be reflected should that reality occur. That's why it is crucial that both the media and investors concentrate on what is actually said as opposed to what they want to try and interpret from the words (potentially for their own ends).

        There was an interesting research paper posted by the ECB which I read at the weekend entitled "Loose Lips Sinking Markets". The paper found that the yield spread of both Irish and Greek sovereign bonds over the German bund at the height of the euro crisis (2009-2011) was affected by comments made by both national politicians and international actors, such as ECB board members. Moreover what was also discovered was that negative comments, even by relatively minor politicians, had a more damaging impact on the yield spread than the positive impact of upbeat comments. Mark Carney has arrived in the UK with many investors and indeed the media looking at him as being the savior with the ability to pull out all the tools necessary to help guide and shock the British economy back to prolonged and effective growth. However he only holds some of the tools. A big assistance in managing this also lies with the politicians. In the UK especially, fiscal policy is going to play an important factor in getting the UK back to health (more on this in another blog). As the aforementioned paper demonstrates, the words of politicians (on all sides of the political spectrum) in addition to those of the financial guardians could have crucial impact on not only the behavior of the markets, but also as a result the behavior of the economy. The media (and investors) also bear responsibility for ensuring that there is no overreaction to a slightly adverse economic indicator or indeed a flippant or point scoring comment from an opposition politician.

                The last Canadian to arrive on these shores with such an expectation to bring back success to the UK ended up a US Open finalist, but ultimately couldn't go that final step of the way to bring cheer to the country. Greg Rusedski at the time was able to share that burden of expectation of the nation with Tim Henman, himself only capable of a string of semi-finals. Mark Carney will need to hope to share his burden with George Osbourne, for now at least. If I were to offer Mr. Carney some advice (in case he was looking for it), it is likely he will learn soon enough the UK media's love for building someone up to the top only to try and displace him in the cruelest way possible should they not be able to quickly provide the success required. I would hope this doesn't dissuade him from his efforts to provide more clarity and forward thinking for the way forward for monetary policy in the UK (He might also want to avoid using humour given it's consequences for his Aussie counterpart).  As for being able to deal with the expectations of a nation being placed on one man's shoulders and succeeding, well I suggests he gives Andy Murray a call.

Bringing Down the House – When is it fair to label Speculation as “Gambling”?

                 This past week I stumbled upon an old book from Uni creatively called “Investments” by Bodie, Kane & Marcus (5^th Edition McGraw Hill Irwin Publishers – in case you’re interested, or in case they’re reading). As I flicked through it I came across a section which discussed risk, speculation and gambling and I was intrigued. After 8 years supporting various trading desks I thought it might be interesting to see how the literature determines the difference between speculation and gambling.

Speculation is, to quote the section (p.156):

““the assumption of considerable business risk in obtaining commensurate gain”…………By “commensurate gain” we mean a positive risk premium, that is, an expected profit greater than the risk free alternative”……….by “considerable risk” we mean that the risk is sufficient to affect the decision. An individual might reject a prospect that has a positive risk premium because the added gain is insufficient to make up for the risk involved”.       

Gambling on the other hand is defined as:

“”to bet or wager on an uncertain outcome”…………Economically speaking, a gamble is the assumption of risk for no purpose but enjoyment of risk itself, whereas speculation is undertaken despite the risk involved because one perceives a favourable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium to compensate risk averse investors for the risks they bear.”

      That last line for me is the most interesting because it suggests a fine line between gambling and speculation, and one which implies some level of one’s perception is the only difference.

                    Ever since I started in working in banking I have been asked by friends and family not in the industry “isn’t trading on the stock market just gambling?” More often than not I took the official approach – investors are taking informed decisions based on the information out there to take a calculated risk in determining whether a stock was going to go up, or down, and as such this enabled them to verify whether the risk premium involved outweighed the risk. Most people at that point nod politely (or nod off!) and admit they don’t understand the market and figure that other people must have more knowledge to be able to make truly informed decisions.

                 As the definition above lays out, in order for a trade to be truly speculative as opposed to a gamble, you need to determine an expected return based on the probability of a variety of outcomes on that trade, using all the information available, and not only for this return to be above the risk free rate (normally seen as being either US Treasury rates or in this country UK government Gilts), but also for the additional risk involved to be adequately compensated by the expected return above that rate.  

                  Of course to make that decision and not feel like you’re “taking a punt” you need to feel that you have assessed all the relevant available information. You then of course have to realistically assess the risk of successful and non-successful outcomes. If you’re looking at a longer time horizon, say 10 years, for your investment, then you have a decent time frame to realistically consider your potential investment’s risk vs reward profile and perceive yourself to be making an informed investment based on information you've gathered and that supplied by others.

          But what about on a day to day basis? Can we really say it’s possible to properly ascertain the risk versus reward in the very short term and conclude that on the whole we are making a speculative investment and not just a gamble i.e. we have perceived the risk premium to adequately compensate for the risk involved. I would say, at the current moment this seems unlikely in most cases. We’re currently living in a world where the market falls at an indication things might improve, rises when the economy performed worse than originally thought, but then can rise or fall when other economic indicators indicate improvement. 

        As I've mentioned in previous blogs a rational investor would surely have expected a rise in the S&P 500 off the back of the Fed announcement. But Let’s say you took the contrarian view. You “speculated” based on the information you felt you knew that the S&P 500 would go on a downward spiral for the next couple of weeks? After all if you felt that Fed tapering was bad news surely the closer this comes to being put into action then the more the market should fall. As a result you sold on the day of the news, June 19th. Well even then you’d most likely be disappointed with the market falling slightly again for the next few days but effectively as of the close last night it was only slightly below the closing level of June 19^th. So you’re almost back to where you started but you’ve also used resources in potentially going from previously being long to now being short as well as incurring transaction costs. Speculation of course doesn't mean you’re always going to be right and make money, but can an investor really make very short term perceptions as to market behaviour and risk/reward payoffs in the current topsy turvy markets and still call it speculation?  

        

              A few years ago I read a book called Bringing Down the House, by Ben Mezrich, in which he tells the true (well close to true) story of a group of pretty smart MIT students who have a remarkable ability to count cards to a high degree (There was also a film starring Kevin Spacey called 21, but the book was better). This group led, by their university professor, go to casinos around the country, and ultimately to Vegas, hitting the blackjack tables and raking in millions of dollars. Their biggest risk was non-financial – they had to hope to avoid physical intimidation should the casino ever cotton on to their method. It was a short term speculative investment which they knew they had a good probability of coming good from. The big difference here is that they knew all the elements and were able to produce a strategy which had winner written on it most of the time. 

            There is no such strategy or methodology attributable to the current markets in the short term. When good news could mean up or down then speculation cannot be possible. If you’re looking at an everyday individual investor and they think about the medium term, at least 4-5 years, it’s fair to say most people will be close to speculative in how they invest their money in the market. But try to “speculate” on a daily, weekly or monthly basis, you might find you’re just struggling to count cards in Vegas. The problem is you don’t know how many decks of cards they’re using!!